Recap

Back in September, we gave Alibaba (NYSE:BABA) a « Sell » rating because we were concerned their corporate restructuring could weaken the connections between their business units. The next day after we published that report, Alibaba’s ex-CEO Daniel Zhang unexpectedly resigned. Zhang had been slated to take over the leadership of Alibaba Cloud. Then during Alibaba’s Q3 earnings announcement, they shocked everyone by saying they’re scrapping the reorg plan altogether – at least for now. They also canceled plans for a subsidiary IPO.

While canceling the reorganization may not have been as negative as we first feared, it has still caused some other challenges that we now need to address. So lots of drama and mixed signals coming out of Alibaba lately. Let us break it down for investors:

Alibaba’s Corporate Restructuring

When Alibaba announced they were halting restructuring plans and scrapping the cloud business IPO, they claimed recent U.S. semiconductor export restrictions had created too much « uncertainty. »

This is not a compelling reason in our view. The timing seems too convenient after Daniel Zhang’s surprise resignation. Let’s be real – Nvidia (NVDA) still gets clearance to supply lower-grade A100 and H100 chips to China. So Tencent, Baidu (BIDU), and other « private » competitors have access to similar tech that Alibaba Cloud does.

In our view, part of the rationale behind the restructuring was to loosen the chokehold of Chinese regulators and boost innovation. As you’ll recall, Ant Group’s blocked IPO attempt brought intense government scrutiny on Alibaba. Since then, there’s been a huge Communist Party presence within Alibaba – complete with 25 secondary organizations and 150 local branches monitoring activities. The reorg could have created some much-needed breathing room from all that.

But Daniel Zhang’s sudden departure was likely a big red flag that the plan was falling apart. And sure enough, a short time later management called the whole thing off.

So while trying to unwind from the government’s grasp made strategic sense on paper, in practice it seems to have been an utter failure so far. And that tangled web Alibaba finds itself in shows no signs of straightening out anytime soon.

Alibaba Cloud Losing Ground to Huawei

Other than regulatory concerns, Alibaba Cloud has been losing ground to competitors like Huawei lately.

Take Huawei for example. As of Q1 2023, they ranked #2 in China’s cloud infrastructure spending – right on the heels of #1 Alibaba. But Alibaba Cloud revenue fell 2% year-over-year that quarter, even as Huawei surged 19% ahead. For the whole Chinese cloud sector, growth averaged around 6%.

Then in Q2 and Q3, Alibaba crawled ahead at just 2% and 4%, respectively. Meanwhile, forecasts call for China’s overall cloud services market to expand 12% in 2023. So simple math suggests if Huawei maintains rapid growth in the high teens, they’ve continued eating into Alibaba’s lead.

The lack of transparency in China’s tech scene makes precise market share hard to pin down. But the dynamic seems clear – Alibaba Cloud appears stagnant while Huawei charges forward. And that’s got to worry investors who expect sector-leading growth from the top dog.

A big reason for Huawei’s cloud success is clear backing from the Chinese government. Huawei Cloud has developed its own distributed relational database called GaussDB which is specially designed for financial institutions and government agencies. The latest Gartner report names Huawei Cloud as the ONLY global cloud provider to be marked as a « Customers’ Choice » for cloud database management systems. Huawei Cloud raked in 89 customer reviews on the Peer Insights platform this past year. And across all that feedback, they managed to earn an overall rating of 4.8 out of 5 stars.

Just look at some of their marquee customers – Industrial & Commercial Bank of China, the world’s largest bank; China Communication Bank, a top 4 state-owned Chinese bank; and state power giant CTG.

This seems to be part of Beijing’s strategy to nurture homegrown champions like Huawei as an offset to losses in other sectors from U.S. sanctions. Propping up Huawei Cloud subtly weakens arch-rival Alibaba while advancing China’s technological independence.

It’s also a manifestation of China’s longstanding « state advances, private sector retreats » policy framework. Despite 40 years of market-oriented reforms, Xi and the Communist Party are still intent on firmly controlling the commanding heights of the economy.

Of course, turning back the clock completely after decades of private sector dynamism is easier said than done. So for now, Beijing seems to be selectively supporting companies like Huawei and Semiconductor Manufacturing International Corp with state contracts and favors – bolstering them as champions of Chinese innovation and government priorities.

This two-pronged approach – elevating state favorites while putting pressure on wildcards like Alibaba – may well be the strategy going forward. Investors need to watch closely on a case-by-case basis whether Chinese companies have the Party’s blessing – it could make all the difference.

Government-Owned Players Rise

IDC’s report leaves out huge cloud capacity from China’s state telcos – China Telecom, China Mobile, and China Unicom. They were mandated by Beijing to transition official state operations over to their government-backed cloud platforms. Between all three, they may rival Alibaba in scale if counted properly.

Just look at the numbers.

During the first three quarters of 2023, China Telecom made nearly 99.7 billion RMB, an increase of 16.5%, by offering digitization services like cloud computing. Alibaba saw a flat growth of 71.2 billion RMB during this period, while China Unicom saw a 36.6% increase in cloud business, booking 36.7 billion RMB over that period.

Alibaba’s Shrinking Domestic Market Share and Limited Global Presence vs. PDD

In the world of e-commerce, PDD (PDD) has shown itself to be a rising star that may soon surpass the current leader Alibaba. Breaking down the revenues, we see PDD separates its revenues into « online marketing services » like ads and « transaction service » from actual sales. Its domestic Pinduoduo app earns more from Chinese shoppers clicking on and viewing ads, while Temu, its international platform, makes most of its money from direct sales under a consignment model.

Since Temu focuses on expanding overseas, it makes for an interesting comparison to Alibaba’s operations outside of China. The numbers show that Alibaba is likely losing ground in its domestic market. In addition, PDD may have more overseas exposure than Alibaba given that its transaction service revenues have surpassed Alibaba’s overseas revenues.

Alibaba Underperforms PDD in Efficiency

Alibaba does not necessarily have a strong moat despite its higher revenues. A cost-efficient business model has the potential to unseat the market leader. When comparing Alibaba to the latest September Quarterly Rev/Employee metrics, PDD is 5 times higher.

The three main stages of a traditional CRM cycle are:

1. Acquisition,
2. Conversion, and
3. Retention of customers.

Below, we will discuss the cost comparison between the models from Alibaba and PDD at various stages.

Domestic Market Dynamics: Marketplace model vs C2M model

Customer Acquisition Costs

Domestically, Alibaba’s bread-and-butter is its Taobao marketplace. Taobao operates a traditional marketplace connecting buyers and sellers. Taobao’s model leaves it up to individual merchants to attract buyers and drive sales conversions for their products.

In contrast, PDD’s domestic platform Pinduoduo has developed a more cost-efficient consumer-to-manufacturer (C2M) and a group buy model. Pinduoduo’s main focus is on serving white labels, low-cost merchants, and encouraging users to make group purchases to help lower its customer acquisition costs.

The benefit is there is tons of selection across countless categories to browse on Taobao. However, its addressable market is smaller due to its selection focus than Pinduoduo’s price focus. This can lead to higher customer acquisition costs as Alibaba must spend more on marketing to bring in new buyers and sellers across numerous categories.

Customer Conversion Costs

Pinduoduo made an aggressive move early on by instituting a « refunds only » returns policy across their marketplace. Building consumer trust helps to lower Pinduoduo’s conversion costs. This was unprecedented compared to traditional e-commerce sites. The refund-only policy may irritate merchants if the refund rate rises, as the platform prioritizes maximizing merchant marketing dollars. But even with initial grumbling from some sellers, Pinduoduo’s financial growth since rolling out the refund policy tells the true story. It seems the focus on a stellar customer experience and peace of mind during the buying process only strengthened Pinduoduo’s traction over time.

Customer Retention Costs

As for customer retention costs, Alibaba relies on merchants to provide newness to retain customers. But by trying to be everything for everyone, their efforts become fragmented and less efficient overall. Pinduoduo’s concentration as essentially « the » go-to for low-cost agriculture items from the farm direct to the consumer gives it an edge.

Pinduoduo has done an amazing job establishing itself as the top marketplace for agricultural products in China. Because food and agriculture purchases are so frequent, most customers use PDD on an ongoing basis rather than just one-off transactions as on Taobao. This high purchase frequency and habit formation means Pinduoduo enjoys lower retention customer costs.

PDD has been aggressively expanding in this business by charging 0 commission on agriculture products. A couple of sources have suggested that PDD’s Doudou grocery service is now ranked first in China, surpassing its major competitor Meituan. Doudou Grocery’s profitability is around 3%. Doudou also has 26000 stock keeping units (« SKUs ») and has cheaper prices compared to Meituan on 60 percent of those SKUs. This suggests that Doudou Grocery has a solid competitive position in the market.

PDD Receives Government Support

On top of that loyalty and low costs from purchase frequency, Pinduoduo sees additional support from Chinese government programs aimed at modernizing and improving technology usage in agriculture. Now, we can’t say for certain whether PDD has gotten straight-up cash subsidies from the Chinese government. But there’s no doubt PDD’s business aligns nicely with official policies to help rural farmers.

Discount Taobao Is Struggle

Alibaba tried to fight back in 2020 with the launch of Discount Taobao to mimic Pinduoduo’s C2M model. But, Alibaba was late to the game. On top of that, trying to integrate C2M into the existing Taobao marketplace made for a confusing seller experience that never gained much traction. Without the first-mover advantage or purpose-built C2M platform, Alibaba has struggled to replicate Pinduoduo’s e-commerce model through Discount Taobao.

International: Local Strategy vs Consolidated Model

Internationally, Alibaba has invested in various local e-commerce players abroad like Lazada in Southeast Asia and Trendyol in Europe. The downside is these are still relatively small, fragmented markets compared to other Western countries such as the U.S. And Alibaba has to grow the platforms in each region rather than expand a unified brand overseas.

PDD took a different approach with its international efforts. Overseas, PDD built Temu as a consolidated, global brand that represents PDD everywhere outside China. Temu operates under a consignment model, meaning Pinduoduo handles logistics, inventory, and shipping in-house rather than relying on third-party sellers. This consignment setup gives Temu and PDD much more control over tailoring the customer experience in each market.

Early momentum for Temu shows that an exportable, recognizable identity gives PDD an expansion edge over Alibaba’s decentralized overseas ventures.

Valuation: Alibaba’s Diminishing Market Position

The market always prices in future expectations – often rewarding disruptors over incumbents. Look at how Amazon’s (AMZN) market cap eclipsed Walmart’s (WMT) back in 2016, despite trailing on actual sales.

In that context, it seems risky to view Alibaba stock as « cheap » just because multiples hit historic lows. This is a firm hemorrhaging competitive strengths on multiple fronts:

• Regulatory vise grip at home limiting growth
• Lost cloud dominance to a state favorite in Huawei
• Domestic e-commerce lead fading quickly to upstart Pinduoduo
• International ambitions now playing catch up to Temu too

Put simply, Alibaba’s competitive « moat » has sprung dangerous leaks on every side. Market share and clout are gushing away day and night.

Sure the valuation math looks temptingly « cheap » for such a beaten-down stock. But buyers tempted to dip their toes could still get burned badly here.

How to Change the Ship’s Course

Things must be getting difficult at Alibaba. Even founder Jack Ma is out there egging on major changes – he recently praised scrappy upstart PDD as the kind of creative thinking Alibaba needs.

While Alibaba’s decision not to continue the reorganization isn’t solely negative, it does mean they have an opportunity to better consolidate their data and analytics capabilities – which could have been a real competitive edge. At the same time, they’re still facing tough competition from government-backed rivals like Huawei and PDD.

In our view, we wouldn’t say a turnaround for Alibaba is unlikely – but without that ambitious restructuring, it may eventually require large-scale layoffs for them to streamline operations and reduce costs. Coordinating across Alibaba’s multiple business lines and 224,000 employees under varying models has its challenges too. There still could be a path forward, but it takes time and its peers are not waiting.

Conclusion

Jack Ma is calling for Alibaba to boost its innovation efforts if it wants to stay competitive. The challenge is, PDD has beaten them on the e-commerce front by running a much leaner, targeted operation. Advancing to match Huawei’s cutting-edge tech prowess would require Alibaba to push the envelope and adapt. But truthfully, it’s tough for an enormous, established company like Alibaba to foster agility and transformation overnight.

In addition, investors shouldn’t expect Alibaba layoffs to have the same turnaround effect as in Western firms. For one thing, Chinese government monitoring ensures restructuring won’t loosen their controlling grip on operations.

It’s fair to say Alibaba has experienced notable turnover in top talent over the past few years. The current CEO has an extensive background in finance and operations. However, some could argue a bolder, more transformational visionary at the helm may be what the company needs to recapture its competitive edge through more disruptive innovations.

We see competitors Huawei and PDD continuing to steal share in cloud and e-commerce respectively. The trends are clear and any internal chaos from restructuring would only accelerate the declines. We rate Alibaba stock a SELL here.